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Commission-Free Trading: Is It a Free Lunch?

In breaking news, Charles Schwab roiled markets by announcing that they will be eliminating web and mobile trading charges. The announcement sent shares of Schwab down 7% as markets wondered how Schwab (and TD Ameritrade, who also cut commissions to zero as well on their response) might replace the approximately $90 million dollars of revenue generated by commissions.  

Some have suggested this is a “radical realignment” of the brokerage world (indeed, markets seemed to think so as several other online brokerages saw their share value drop in response to the news), but is in fact following a longer-term trend in the online brokerage world. For instance, many of our clients invest in commission-free ETFs with TD Ameritrade and many brokerages have started offering free trades (JP Morgan Chase offered 100 free trades to new clients and Schwab had previously offered free trades for a year) as an inducement for clients to sign on to their platform. Managed clients at many wirehouses already benefit from “free” trades in managed accounts (though the skeptic in us will mention that sometimes the investor may have been better off paying trading costs rather than a higher “wrap” fee). Ultimately, from lowering fees on ETFs to trading costs on both equities and ETFs, the cost of being an investor has been in gradual decline over the last several decades.  

However, as they say in economics: TINSTAFL (“There is no such thing as a free lunch”), and so the question for many is how does Schwab plan to make up this loss in revenue? (Editors note: This is a stupid acronym.) The first is to realize that Schwab is basically functioning already as a bank: in its recent quarterly earnings report it noted that it had earned nearly $1.4 billion on deposits alone in the quarter: essentially Schwab brokerage accounts pay out very little in interest and they earn money on the difference (their net interest rate is roughly 2.4%). Additionally, Schwab also offers loan products through pledged asset loans and other lending products, and we expect an increase in focus on these products as they (and other custodians) compete for wallet share.

Consequently, simply by bringing more money through the door they will currently earn 2.4% on cash sitting in clients’ accounts. The other way that some have suggested Schwab will earn money is by handling the spread. Every trade has two prices: the price the buyer wants to pay and the price the seller wants to get (the bid and the ask). A brokerage can make a few pennies per share by selling at the buyer’s price and buying at the seller’s price (this is called market-making). By encouraging more trading (by eliminating commissions), Schwab and other custodians may make some of that back by increased revenue from market-making. (As a note, Walkner Condon frequently works with TD Ameritrade’s block trading desk to help manage the bid-ask spread for larger trades and thinly traded ETFs. For questions about how that works, speak with your advisor). 

For more on this market-making, the Wall Street Journal has an article discussing this focusing on Robinhood, another fintech startup that has built its business on “free” trading. Interactive Brokers also is rolling out a free trading platform and it appears that they are being more transparent on the market-maker markups versus their SmartRouting system.

Ultimately, while it is likely that other online brokerages will follow Schwab’s lead, but this elimination of trading costs is not a revolution, but more an evolution. Fortunately for investors, costs relating to trading and holding investment products continue to trend downwards. While it is not a free lunch, we are getting more value for our meal.

Keith Poniewaz & Clint Walkner